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1 MACROECONOMICS Should Policy Be Active Or Passive?

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1 MACROECONOMICS Should Policy Be Active Or Passive? In this chapter, you will learn… C H A P T E R 14 …about two policy debates: Stabilization Policy 1. Should policy be active or passive? 2. Should policy be by rule or discretion? MACROECONOMICS SIXTH EDITION N. GREGORY MANKIW PowerPoint® Slides by Ron Cronovich © 2007 Worth Publishers, all rights reserved CHAPTER 14 Stabilization Policy slide 1 Growth rate of real GDP, 1970-2006 Question 1: Percent 10 change from 4 8 quarters Should policy be active or earlier 6 passive? Average 4 growth rate 2 0 -2 -4 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 14 Stabilization Policy slide 2 Increase in unemployment during Arguments for active policy recessions increase in no. of . Recessions cause economic hardship for millions peak trough unemployed persons (millions) of people. July 1953 May 1954 2.11 . The Employment Act of 1946: Aug 1957 April 1958 2.27 “It is the continuing policy and responsibility of the April 1960 February 1961 1.21 Federal Government to…promote full employment December 1969 November 1970 2.01 and production.” November 1973 March 1975 3.58 January 1980 July 1980 1.68 . The model of aggregate demand and supply July 1981 November 1982 4.08 (Chaps. 9-13) shows how fiscal and monetary July 1990 March 1991 1.67 policy can respond to shocks and stabilize the March 2001 November 2001 1.50 economy. CHAPTER 14 Stabilization Policy slide 4 CHAPTER 14 Stabilization Policy slide 5 1 Arguments against active policy Automatic stabilizers Policies act with long & variable lags, including: . definition: inside lag: policies that stimulate or depress the economy the time between the shock and the policy response. when necessary without any deliberate policy . takes time to recognize shock change. takes time to implement policy, . Designed to reduce the lags associated with especially fiscal policy stabilization policy. outside lag: . Examples: the time it takes for policy to affect economy. income tax If conditions change before policy’s impact is felt, . unemployment insurance the policy may destabilize the economy. welfare CHAPTER 14 Stabilization Policy slide 6 CHAPTER 14 Stabilization Policy slide 7 Forecasting the macroeconomy The LEI index and real GDP, 1960s 20 Because policies act with lags, policymakers must The Index of 15 predict future conditions. Leading Economic 10 Two ways economists generate forecasts: Indicators 5 . Leading economic indicators includes 10 data series that fluctuate in advance of the data series 0 -5 economy (see p.258 ). annual percentage change . Macroeconometric models -10 Large-scale models with estimated parameters 1960 1962 1964 1966 1968 1970 that can be used to forecast the response of source of LEI data: Leading Economic Indicators The Conference Board Real GDP endogenous variables to shocks and policies CHAPTER 14 Stabilization Policy slide 8 CHAPTER 14 Stabilization Policy slide 9 The LEI index and real GDP, 1970s The LEI index and real GDP, 1980s 20 20 15 e 15 g n 10 a 10 h c 5 e 5 g a 0 t 0 n e -5 c r -5 e p -10 l -10 a u -15 n -15 annual percentage change n -20 a -20 1970 1972 1974 1976 1978 1980 1980 1982 1984 1986 1988 1990 source of LEI data: Leading Economic Indicators source of LEI data: Leading Economic Indicators The Conference Board Real GDP The Conference Board Real GDP CHAPTER 14 Stabilization Policy slide 10 CHAPTER 14 Stabilization Policy slide 11 2 Mistakes forecasting the 1982 recession The LEI index and real GDP, 1990s 15 e e t g 10 a n r a t h n c 5 e e m g y a t 0 o n l e p c r m e -5 e p l n a U u -10 n n a -15 1990 1992 1994 1996 1998 2000 2002 source of LEI data: Leading Economic Indicators The Conference Board Real GDP CHAPTER 14 Stabilization Policy slide 12 Forecasting the macroeconomy The Lucas critique Because policies act with lags, policymakers must . Due to Robert Lucas predict future conditions. who won Nobel Prize in 1995 for rational expectations. The preceding slides show that the . Forecasting the effects of policy changes has forecasts are often wrong. often been done using models estimated with This is one reason why some historical data. economists oppose policy activism. Lucas pointed out that such predictions would not be valid if the policy change alters expectations in a way that changes the fundamental relationships between variables. CHAPTER 14 Stabilization Policy slide 14 CHAPTER 14 Stabilization Policy slide 15 An example of the Lucas critique The Jury’s out… . Prediction (based on past experience): Looking at recent history does not clearly answer An increase in the money growth rate will reduce Question 1: unemployment. It’s hard to identify shocks in the data. The Lucas critique points out that increasing the . It’s hard to tell how things would have been money growth rate may raise expected inflation, different had actual policies not been used. in which case unemployment would not necessarily fall. Most economists agree, though, that the U.S. economy has become much more stable since the late 1980s… CHAPTER 14 Stabilization Policy slide 16 CHAPTER 14 Stabilization Policy slide 17 3 The stability of the modern economy Question 2: n 4.0 o i t a i Volatility 3.5 Should policy be conducted by v e of GDP d 3.0 d rule or discretion? r rule or discretion? a d 2.5 n a t 2.0 S 1.5 1.0 Volatility of 0.5 Inflation 0.0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 14 Stabilization Policy slide 18 CHAPTER 14 Stabilization Policy slide 19 Rules and discretion: Arguments for rules Basic concepts . Policy conducted by rule: 1. Distrust of policymakers and the political Policymakers announce in advance how process policy will respond in various situations, . misinformed politicians and commit themselves to following through. politicians’ interests sometimes not the same . Policy conducted by discretion: as the interests of society As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time. CHAPTER 14 Stabilization Policy slide 20 CHAPTER 14 Stabilization Policy slide 21 Arguments for rules Examples of time inconsistency 2. The time inconsistency of discretionary 1. To encourage investment, policy govt announces it will not tax income from capital. def: A scenario in which policymakers But once the factories are built, have an incentive to renege on a govt reneges in order to raise more tax revenue. previously announced policy once others have acted on that announcement. Destroys policymakers’ credibility, thereby reducing effectiveness of their policies. CHAPTER 14 Stabilization Policy slide 22 CHAPTER 14 Stabilization Policy slide 23 4 Examples of time inconsistency Monetary policy rules a. Constant money supply growth rate 2. To reduce expected inflation, the central bank announces it will tighten . Advocated by monetarists. monetary policy. Stabilizes aggregate demand only if velocity is stable. But faced with high unemployment, the central bank may be tempted to cut interest rates. CHAPTER 14 Stabilization Policy slide 24 CHAPTER 14 Stabilization Policy slide 26 Monetary policy rules Monetary policy rules a. Constant money supply growth rate a. Constant money supply growth rate b. Target growth rate of nominal GDP b. Target growth rate of nominal GDP . Automatically increase money growth c. Target the inflation rate whenever nominal GDP grows slower than . Automatically reduce money growth whenever targeted; decrease money growth when inflation rises above the target rate. nominal GDP growth exceeds target. Many countries’ central banks now practice inflation targeting, but allow themselves a little discretion. CHAPTER 14 Stabilization Policy slide 27 CHAPTER 14 Stabilization Policy slide 28 Monetary policy rules The Taylor Rule a. Constant money supply growth rate iff = π + 2 + 0.5 (π – 2) – 0.5 (GDP gap) b. Target growth rate of nominal GDP where c. Target the inflation rate iff = nominal federal funds rate target d. The Taylor rule: Y !Y GDP gap = 100 x Target the federal funds rate based on Y . inflation rate = percent by which real GDP . gap between actual & full-employment GDP is below its natural rate CHAPTER 14 Stabilization Policy slide 29 CHAPTER 14 Stabilization Policy slide 30 5 The federal funds rate: The Taylor Rule Actual and suggested iff = π + 2 + 0.5 (π – 2) – 0.5 (GDP gap) t 12 n e c If = 2 and output is at its natural rate, r 10 Actual . π e then fed funds rate targeted at 4 percent. P 8 . For each one-point increase in π, 6 mon. policy is automatically tightened to raise fed funds rate by 1.5. 4 . For each one percentage point that GDP falls 2 Taylor’s Rule below its natural rate, mon. policy automatically 0 eases to reduce the fed funds rate by 0.5. 1987 1990 1993 1996 1999 2002 2005 CHAPTER 14 Stabilization Policy slide 31 CHAPTER 14 Stabilization Policy slide 32 Inflation and central bank Central bank independence independence n o i . A policy rule announced by central bank will t a l f work only if the announcement is credible. n i e g . Credibility depends in part on degree of a r e independence of central bank. v a index of central bank independence CHAPTER 14 Stabilization Policy slide 33 CHAPTER 14 Stabilization Policy slide 34 Chapter Summary Chapter Summary 1. Advocates of active policy believe: 3. Advocates of discretionary policy believe: . frequent shocks lead to unnecessary fluctuations in . discretion gives more flexibility to policymakers in output and employment responding to the unexpected . fiscal and monetary policy can stabilize the economy 4.
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